Wednesday, January 29, 2014

The Warren Buffett Argument Against Paying Dividends

One of the main arguments that opponents of dividend investing make is that Warren Buffett has never paid dividends on Berkshire Hathaway (BRK.B). He has managed to reinvest profits and buy more businesses and shares in publicly traded companies. This compounding of profits has catapulted Berkshire’s Book Value from 16 in 1965 to 114,000 by 2012. So if this worked so well for Berkshire Hathaway shareholders, why don’t all companies simply simply discontinue paying a dividend, and reinvest all of their earnings into the business?

While in theory this sounds like an excellent strategy, there are a few issues with it.

The first one is that Warren Buffett is an outlier. He is the best investor the world has ever seen, and as a result his skilled allocations of capital have resulted in great amounts of wealth for shareholders. Unfortunately, I cannot think of many other managers today, which are likely to reach his status in a few decades. I know that the Oracle of Omaha is an outlier, because there is only one Buffett, but 106 dividend champions. As a result, I find it much more probable that an investor can identify the next company to boost distributions for 25 years in a row, versus identifying the next Berkshire Hathaway.

The second issue is that it is extremely difficult to keep reinvesting money in your business to grow and achieve the same rates of return on any additional money you put to work. Essentially at some stage you enter a point of diminishing returns. If McDonald’s (MCD) or Wal-Mart Stores (WMT) simply doubled the number of locations they had, this would not automatically double sales and profits. In fact, they would probably go bankrupt, as new stores would likely cannibalize sales of existing stores, while certainly doubling the amount of costs. In addition, it would take time to find suitable locations, build the stores, and then attract customers to shop there on a recurring basis. McDonald’s (MCD) almost got in trouble in 2002, because the company was simply focusing on increasing number of stores, without paying attention to same store sales in the US for example. This had worked for the first 40 years in the company’s history, but once there was a store in every major intersection, focusing on improving the customer experience through store renovation and new product introduction has been key in improving same-store profitability.

The third issue is that companies cannot simply merge with competitors or buy unrelated businesses in order to grow. Integrating business systems, different products and cultures can be extremely difficult, time consuming and costly. Most acquisitions don’t work and fail to deliver the synergies expected. In addition regulators do not like too much concentration in industries. A prime example was the failed acquisition of T-Mobile by AT&T (T). For a few years, it could have been argued that insurance company AIG was following a strategy similar to Buffett’s at Berkshire. The company had purchased a ton of unrelated to insurance assets, including the telecom company of Bulgaria for example. Unfortunately, it did not work.

The fourth issue is that while Berkshire does not like paying a dividend, it does seem to invest in businesses that distribute a large portion of their excess cashflows to the parent, so that Buffett can invest the money for the firm. There are many examples of Buffett’s love for dividends. The first one is See’s Candy, which was described as a great investment that generated high yield on cost despite the low initial and recurring capital requirements of the business. These cashflows were then used to purchase other businesses. Another famous investment by Buffett is his purchase of Coca-Cola (KO) shares in 1988. His company is currently earning a double-digit yield on cost on this investment, and the amount of dividend income is expected to continue its upward trend. This was in particular discussed by Warren in his 2011 letter to shareholders. In addition, Berkshire’s dividend portfolio generates over 1.5 billion in annual dividend income. That does not take into consideration the $300 million it generates from Bank of America preferred stock, nor does it consider the cash distributions from Burlington Northern Railway and the countless other businesses that Berkshire owns. In fact, I have argued that investors, who are inspired by Buffett, should build their own Berkshire Hathaway using dividend paying stocks.

Last but not least, book values and stock prices do not always have a one to one relationship. For example, during the 1998 – 2000 period, Buffett was often cited as being out of touch with reality since he didn’t invest in tech stocks. This was the period when red hot technology stocks dominated investor interests, and Buffett was often ridiculed for his avoidance of the sector. As a result, after Berkshire’s stock reached a high in June 1998 of 84,000, it fell all the way to 43,000 in February 2000. The stock didn’t exceed its high until November 2003. Investors who simply held on to the stock, did not realize any return on investment for five long and difficult years, despite the fact that book value per share increased during the same period. In contrast, investors in dividend paying stocks have received positive reinforcement every three months, whenever the dividend checks were deposited in their brokerage accounts. Getting paid to hold shares with improving fundamentals is much easier done than holding non-dividend stocks during turbulent market conditions, hoping that the market would realize the investment’s true potential.

In summary, an investment in Berkshire Hathaway (BRK.B) exposes our investor to the whims of Mr. Market. An investment in Dividend Paying Stocks still makes the investor partially vulnerable to the whims of Mr. Market when it comes to stock prices. However, dividends provide a direct link between the company’s operating performance and investors’ return on investment, which are not dependent on the whims of Mr. Market. To paraphrase some of Mr. Buffett’s words, even if they closed the stock market for five years, dividend investors would keep getting their dividend checks on a regular basis. And these checks would be bigger in year five than in year one.

Full Disclosure: Long KO, MCD, WMT and BRK.B

Relevant Articles:

Warren Buffett Investing Resource Page
Dividend Investors are Getting Paid for Holding Dividend Paying Stocks
Warren Buffett’s Dividend Stock Strategy
Build your own Berkshire with dividend paying stocks
How Warren Buffett made his fortune

8 comments:

  1. I discovered the blog a few weeks ago and I like the insight. I've read through it enough to where my google now widget gives me notices and links to your new posts.

    I found the blog because I was googling about dividend investing, in an effort to teach myself the pros and cons vs growth stock investing.

    I saw this headline and thought "sweet he's going to address some cons, hopefully he touches on the big one that I keep looking for".

    But...you didn't. So I'm not trying to be a jerk or anything, after all this is my first comment here. I think the biggest "con" is the tax effect. Doesn't Buffett himself touch on this too? As an investor, when you get dividends, you have to pay (usually) 15% tax every time they come. When you buy and hold a growth stock, you just pay the 15% when you sell. So if you hold for 10 years, you're effectively "reinvesting" the returns tax-free. Whereas when you reinvest dividends the tax man takes his share out and you lose out on the extra compounding. It'd be like selling your growth stock every year and buying it back (only you can't buy back as much cause you have to pay 15% in taxes).

    I'm not against dividends - afterall the idea of replacing my income stream makes me warm and rosy. I think it boils down to risk and therefore diversification. The stocks you list are solid, established, safe, blue chip style companies. There's a lot to be said for that, but I personally am enjoying the mixing of dividend and non dividend (essentially adding some risk with the potential for faster returns). My personal favorite stock is GOOG...the new Be

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  2. Hello DGI,

    Nice article. I have always disliked the characterization of 'tech' stocks. As if no company, other than computer, cell phone and companies that make ICs are involved in 'technology'. Many companies, many that pay dividends, are involved in the 'technology' of their respective business. Everyday, in labs across the planet, labs at MMM, JNJ, PH, DOV, MKC, HRL, MO, PM, and others, companies engage in the 'technology' of their business segment. We don't tend to think of these as 'tech' companies, but in many ways, they are.

    Take care,
    A

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  3. I hate when people try to make this argument against dividend stocks.

    First off, like you pointed out, most companies cannot find enough opportunities to get sufficient return on capital to justify retaining all of their earnings. Warren has a knack for finding great opportunities, but other managers have proven a knack for wasting shareholder money. It's better when they decide to pay those profits out to shareholders who can then put it to work themselves.

    I read in one of Warren's writings that when he can no longer find opportunities to invest in that earn returns to justify not paying out the profits to shareholders then he will begin paying out dividends to shareholders.

    Second, like you point out, while Warren may not like paying out dividends (because he can invest that money better than anyone) he sure likes to collect the dividends!

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  4. Hi Jeff,

    Welcome to the site. Thanks for reading.

    Before I get into taxes however, I think that the most important thing you need to do is figure out an investment strategy that works for you, and that you can follow. If you can find growth stocks and make money with them, stick to that, but think about taxes second. I buy Dividend Growth stocks, because they help me achieve my investment goals and objectives. Dividend growth stocks are growing earnings, and dividends. You get the best of both worlds – a rising source of returns that is always positive (dividends) and capital gains as company becomes more valuable. However, my goal is to make money first, and then worry about taxes. They are important, but my goal is to focus on making the money first.

    The other reason why I like dividend growth stocks is because it makes it easier to live off my portfolio in retirement. I am not that smart to correctly time how to sell chunks of my portfolio in order to support myself. I would also hate to have had a portion of my portfolio in a company that is growing earnings, but I have to sell that stock to pay for my expenses. With DG stocks, I spend dividends, and still have appreciation potential.

    The tax question is good though. There are two reasons why I am not discussing taxes here. First one is that not everyone pays 15% on dividends. Some people pay 0% - in fact if you are single and earn less than 46,250/year you pay no taxes on dividends ( 97,500 for married jointly). So you cannot assign worst case scenario of 15%, because it doesn’t apply to everyone.

    The second reason why I don’t talk about taxes is because a very large portion of people’s investable assets are in tax-deferred plans like Roth IRA, 401 (k), IRA etc. So dividend taxation does not really matter to those investors.

    In terms of comparing growth investing to dividend growth investing – those are very broad terms. In theory it sounds great to buy a stock, hold it for 50 years, and only pay taxes if you sold. But I am not sure how growth investing works – if you have to sell for profits every year or two, you might be worse off than in dividend investing from a tax perspective. Of course, strategy is a very individual thing, so you have to determine for yourself what works. I just write down what I think is best for me.

    Google is a great company, I cannot really say anything bad about it. What is your thought about Google's durable competitive advantages though? Do you think it would be as relevant in 20 years as it is today? Or is your timeframe shorter with growth stocks.

    Good conversation!

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    Replies
    1. Thanks for the response. You have valid points and I don't disagree with any of them. I have a steady income from the day job so no need to sell for income, I just sell when I want cash to put in a different stock. Sometimes that works out but usually it isn't worth it.

      I too am relatively new to a Roth but I am fully on board with what you said above (and in a prior article) and put Roth money in dividend payers as a way to get more cash to play with beyond the allowable limits.

      GOOG is diversifying themselves...but within industries they know. Looks like they bailed on the Motorola experiment, but I love their fiber, cars, robotics, chromebooks and android moves, among others. This comforts me on the 20 year relevance thing. I think they have brilliant leaders that aren't in it for the money. They said they won't split their stock either. This is why I liken them to the Berk.A of the "tech" world.

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  5. Hi Dan,

    Warren likes receiving dividends from companies and stocks that Berkshire owns. Berkshire does pay a tax on dividends received on stocks it owns. But yeah, Buffett wants companies that will shower him with cash over time. His perfect business - one that has low capital needs, earns very high returns on capital, and can raise prices so that it can earn more and more in the future - Check See's Candies.

    I agree that Berkshire has way too much cash on hand - although it was helpful during the financial crisis. I think that Berkshire will start paying a dividend within a decade. I think that the foundations might prefer to get cash dividends rather than sell 4-5% of the stock they hold. But you never know.

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  6. Hi Anon,

    Interesting observation. I guess everything could be open to interpretation.

    The way I see it, if you are using technology to produce cigarettes (PM) you are a tobacco company. If you produce spices, you are a consumer staple (MKC). But I think that computers, cell phones, are what "technology" really means these days. If you ask me, a tractor is a piece of technology also. But noone at S&P asks for my opinion though.

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  7. Anonymous,
    You are right more than you know. I work in the patent field. I had a large industrial client once upon a time. You wouldn't believe the number of patents that are filed on railroad cars, guardrails, heavy machinery, etc. All of it is advanced technology. But DGI is right too. Most people think technology largely means things with glowing rectangles.

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